PureFX

How Rising Interest Rates Cause Currencies To Gain On The Foreign Exchange Market

Tue 7th February 2012

In foreign exchange, there are countless things that can influence the exchange rates.

For instance, reports that retail sales are rising in the United States might cause the euro to gain against the UK pound. (This is because improved US retail sales increases risk appetite among investors.) Or news that the Chinese government has boosted its demand for coal might aid the Australian dollar. (This is because the Australian economy depends upon commodities for growth, so high demand is positive.)

Depending on market sentiment on the day these things happen, and depending also on what is happening elsewhere on the planet, these things influence exchange rates to a greater or lesser degree.

In addition to these factors though, there is one thing that is almost guaranteed to influence the exchange rates. This is a change in interest rates.

For instance, the Bank of England might decide to raise interest rates one month to fight rising inflation, in consequence prompting a rising pound. (In the real world, this hasn’t happened since the financial crash in 2008, as the BoE attempts to aid the UK economic recovery.) The European Central Bank on the other hand might decide to cut interest rates one month, to make loans less expensive and hence stimulate growth. (This is the course ECB President Mario Draghi is taking at present.) This then could prompt euro weakness.

This relationship between interest rates and movement in foreign exchange rates is well established then. So why is this?

Foreign Exchange And Government Gilts

It all relates to foreign investment, and the movement of capital into a nation as its interest rate becomes more or less appealing.

For instance, imagine you’re an international investor. You spend your days seeking the most profitable investments (i.e. those that deliver the best return) whether that be government gilts or fudge. Then one month, the Bank of England decides to increase interest rates 0.25%, making the return on British government bonds much more profitable. (This is just like savings in a bank account.) You’d want a slice of that pie, right?

So to purchase UK government bonds, you purchase pounds sterling (national bonds must be bought in the currency of that nation.) That then increases the demand for sterling, making it more expensive, increasing its value on the foreign exchange market. (Just like bread and other household goods, currencies adhere to the laws of supply and demand.)

That is that. How then can you use this information the next time you change currencies? Look out for whether changing interest rates might be about to affect your transaction! If the BoE is raising interest rates one month for instance, it could be worth knowing that could benefit the pound.

To find out more helpful information about making the most of your foreign exchange transactions, call us on +44 (0) 1494 671800 or email enquiries@purefx.co.uk. You can also visit us at foreign exchange specialist Pure FX.